Stocks rebounded strongly in the first quarter thanks to a combination of improving U.S.-China trade relations, the Federal Reserve halting interest rate increases, and a better outlook for corporate earnings. The S&P 500 finished the first quarter of 2019 with the best quarterly return since 2009.
Reflecting on 1Q2019
Starting with U.S.-China trade negotiations, significant progress was made towards a new deal over the past three months, highlighted by the removal of the March 1st trade deal deadline imposed by the administration back in late November. Most of that progress occurred in January and that was one of the initial catalysts for the first quarter rally in stocks.
Turning to the Federal Reserve, perhaps the most impactful event of 1Q was the meeting that took place on January 29th and 30th when the Federal Open Market Committee opted to hold interest rates steady, but also stated that it would be “patient” regarding further rate increases. This shift, which according to the Fed was in response to global economic uncertainty, helped extend the markets’ gains from early January. The expected “pause” in rate hikes was later confirmed by the Fed at the March meeting as official projections for future interest rates showed no more rate hikes are expected in 2019. The Fed keeping interest rates steady should relieve pressure on the economy, and we have already seen some positive effects of that move via a decline in mortgage rates and a rebound in housing sales in the first quarter.
Finally, on a corporate level, earnings results were better than feared in the fourth quarter of 2018. We can see that most clearly in the market reactions to companies that posted disappointing earnings results. According to the research firm FactSet, S&P 500 companies saw the best stock price reaction to negative earnings per share surprises in nine years. Companies that missed analysts’ earnings expectations, on average, fell just 0.40% during the most recent reporting period, compared to an average 2.6% decline over the past five years. Additionally, more than 70% of S&P 500 companies reported earnings that beat estimates, while over 60% of companies reported stronger than expected revenues.
However, while there was clearly more good news than bad during the first quarter, it would be a mistake to think that the economic “coast is clear.” As such, we think it would be premature to expect the second quarter to produce returns similar to the first quarter.
While there was real improvement in U.S.-China trade negotiations, Fed policy outlook and earnings expectations, economic data in the first quarter was disappointing and continued to show a loss of positive momentum not just in the United States, but globally. The current estimate for first quarter GDP is 1.7%, well below the 2.2% growth in the fourth quarter. Internationally, European manufacturing data showed outright contraction in activity in 1Q, while continued Brexit uncertainty is acting as a headwind on the British economy. However, the Chinese and Asian economies have shown some renewed vigor lately leading to optimism that their economies are recovering.
Finally, many parts of the yield curve have inverted, meaning Treasury yields are higher on short term debt compared to longer dated maturities. In the past, that dynamic has sometimes preceded recessions as it reflects pessimism about future economic growth and the resulting negative impact on corporate earnings and stocks. However, since the late 1960s, prior recessions have only happened when the 10-year Treasury Note yield has been at least 50 basis points (0.50%) below the Federal Funds rate, a point that remains far off.
In sum, the market’s performance during the first quarter was a welcomed sight following the volatility and dramatic declines experienced in the fourth quarter of 2018. But while the outlook for markets has improved, notable risks remain. We continue to expect, and are prepared for, more volatility within the context of a still ongoing, multi-year bull market.
1st Quarter Performance Review – A Solid Rebound to Start the Year
U.S. Equity Indexes
The major U.S. stock indices registered their best quarterly performance in a decade in 1Q2019, thanks in part to less restrictive Fed policy and positive progress on the U.S.-China trade conflict. As a result, investors saw broad gains across most market segments and sectors.
By market capitalization, small caps outperformed large caps, which is a reversal of from the fourth quarter. The reduction in global trade tensions, combined with the Federal Reserve signaling no more interest rate increases in 2019, helped small caps to outperform large caps. From an investment style standpoint, growth outperformed value mostly due to strong tech sector returns in 1Q, which is also a reversal from the fourth quarter.
On a sector level, all 11 S&P 500 Index sectors finished the first quarter with positive returns, however tech and real estate sectors were the notable outperformers. Tech was driven higher by improvement in the trade outlook, while the real estate sector benefitted from a decline in mortgage and interest rates following the Fed’s January and March meetings.
Historically defensive sectors underperformed in the first quarter but still finished with positive returns. Consumer staples, healthcare, and financials lagged the S&P 500 as investors rotated to more growth-oriented sectors during the previous three months.
| US Equity Indexes | 1Q Return | 2018 Return |
| S&P 500 | 13.65% | -4.38% |
| DJ Industrial Average | 11.81% | -3.48% |
| NASDAQ Composite | 16.81% | -2.84% |
| S&P MidCap 400 | 14.49% | -11.08% |
| Russell 2000 | 14.58% | -11.01% |
Source: Morningstar
International Equity Indexes
Foreign markets also had a strong start to 2019; but as has been the case frequently over the past year, foreign markets again underperformed U.S. markets, in part because economic readings from Europe showed the EU economy was clearly losing momentum. However, despite that disconcerting European economic data, foreign developed markets outperformed emerging markets. This was due in part to the lack of an official trade deal between the U.S. and China by quarter’s end, along with a stronger U.S. dollar, which is traditionally a headwind on emerging markets. Foreign developed markets were aided by the European Central Bank announcing in March it would restart a stimulus program to help the EU economy.
| International Equity Indexes | 1Q Return | 2018 Return |
| MSCI EAFE NR USD (Foreign Developed) | 9.98% | -13.79% |
| MSCI EM NR USD (Emerging Markets) | 9.91% | -14.58% |
| MSCI ACWI Ex USA NR USD (Foreign Dev & EM) | 10.31% | -14.20% |
Source: Morningstar
Commodity Indexes
Commodities saw strong returns in the first quarter, thanks mostly to a surge in oil prices. Oil rose sharply over the past three months primarily because of supply issues, including the uncertain nature of Iranian sanction waivers, new Venezuelan sanctions that reduced U.S. imports, and a pledge by OPEC to extend previously announced production cuts for all of 2019. Those supply risks offset demand concerns related to disappointing global economic growth. Gold, meanwhile, logged only modest gains for the first quarter thanks to headwinds from a stronger U.S. dollar and lack of acceleration in inflation.
| Commodity Indexes | 1Q Return | 2018 Return |
| S&P GSCI (Broad-Based Commodities) | 14.97% | -13.82% |
| S&P GSCI Crude Oil | 30.68% | -20.49% |
| LBMA Gold Price | 1.26% | -0.93% |
Source: Morningstar
Fixed Income Markets
The leading benchmark for bonds (Bloomberg Barclays US Aggregate Bond Index) saw positive returns during the first quarter, but bond indices lagged stocks, which is a reversal from the fourth quarter of 2018 when investors sought the safety of high-quality bonds.
Looking deeper into the fixed income markets, longer-duration bonds outperformed those with shorter-durations during 1Q, which is a continuation of what we observed in the fourth quarter of 2018. And, given the Fed’s pledge not to raise rates any more in 2019, the outperformance of long duration bonds was expected.
Corporate bonds, both investment grade and high yield, handily outperformed government bonds in the first quarter thanks to a better than expected earnings season, a reduction in macro risks via the apparent U.S.-China trade progress, and the Fed “pause” on interest rate hikes. Both investment grade and high yield bond funds had their best quarterly returns in years.
| US Bond Indexes | 1Q Return | 2018 Return |
| BBgBarc US Agg Bond | 2.94% | 0.01% |
| BBgBarc US T-Bill 1-3 Mon | 0.59% | 1.82% |
| ICE US T-Bond 7-10 Year | 3.06% | 0.90% |
| BBgBarc US MBS (Mortgage-backed) | 2.17% | 0.99% |
| BBgBarc Municipal | 2.79% | 1.28% |
| BBgBarc US Corporate Invest Grade | 6.22% | -3.69% |
| BBgBarc US Corporate High Yield | 8.08% | -2.57% |
Source: Morningstar
Municipal bonds returned 2.8% in 1Q, slightly below their taxable peers. Strong technicals and encouraging fundamentals supported positive performance. High yield municipal bonds were the top performing sector with a 3.8% return, while pre-refunded municipal bonds lagged, only returning 1.3% in 1Q.
Second Quarter Market Outlook
The outlook for markets has improved since the depths of the correction in the fourth quarter. The Fed has backed off additional interest rate increases, corporate earnings have exceeded conservative expectations, and U.S.-China trade relations appear to be moving in the right direction. The recent jobs reports have been volatile, but on average, the economy has added 186,000 jobs over the past three months. Wages grew at a solid pace of 3.4% and unemployment remains at a historically low figure of 3.8%. Core CPI came in at 2.1%, slightly above the Fed’s target, but Headline CPI only rose 1.5% due to lower energy prices.
Those positives have rightly resulted in a strong start to the year. Yet, despite the strong gains this past quarter, we think it would be a mistake to become complacent in this market.
The problems that contributed to the volatility in the fourth quarter of 2018 were three-fold:
- Disappointing economic growth
- Underwhelming earnings results
- Confusion regarding the outlook for future Fed policy
While there has been improvement on two of those three fronts (earnings and Fed policy), none have been fully resolved. There are still legitimate concerns about the pace of economic growth globally following the disappointing economic readings of the last three months.
Additionally, while it is largely expected that the U.S. and China will sign a new trade deal that will result in tariff reduction, as of this writing, that has not occurred. As the past two years have taught us, this administration’s approach is an unorthodox one and anything can happen.
Looking forward to the second quarter, we will be searching for signs that global economic growth has stabilized. Regarding trade, we’ll review and analyze any trade deal to see if it is the economic positive investors believe it will be. Also, we’ll seek out further clarity on the Fed’s plans for interest rates. Meanwhile, this upcoming earnings season will also be important as corporate earnings results and commentary need to reinforce and confirm the optimistic economic and corporate views currently reflected in the stock market. Right now, the analysts’ earnings projections are for negative year-over-year comparisons for the S&P 500 for both the first and second quarters (mainly due to tax cuts in 2018) with a rebound in earnings seen in the third and fourth quarters. For the stock market to sustain its current gains and add to it later in the year, earnings will need to surprise to the upside.
Valuations
With respect to stock valuations after the strong performance experienced in the first quarter, we still maintain an overweighting in stocks vs. bonds as bond yields are historically low compared to the projected earnings power of the S&P 500. Bonds do serve a critical role in managing portfolio risk, but with the current low interest rate environment we are currently underweighting bonds in our more equity-oriented strategies.
Though we remain biased to a U.S. stock allocation, international stock valuations are noticeably cheaper than U.S. valuations, and therefore represent good value. While we can’t say when international stocks will begin to outperform U.S. stocks again, historically these sharply discounted valuations represent attractive entry points for long-term investors. Furthermore, while the ride may feel a bit bumpier, investors with international exposure may be rewarded with higher returns over the long run, particularly if the recently strengthening dollar begins to trend down.
